Profitability ratios: Meaning, types and how to use them

Published Tuesday 20 January 2026

Table of contents

• What do profitability ratios measure?
• What can profitability ratios tell you?
• Types of profitability ratios
• Using profitability ratios in your business
• Gross profit margin
• Net profit margin
• Return on assets
• Return on invested capital
• Track your profitability ratios with the right tools
• FAQs on profitability ratios

Key takeaways

• Track gross and net profit margins regularly to establish baselines and monitor your business's day-to-day operational efficiency in converting revenue into profit.
• Compare your profitability ratios against industry benchmarks, such as those published by the ATO for businesses with turnover up to $15 million, to identify areas for improvement.
• Implement return ratios like ROA and ROIC when your business has significant investments in equipment, property, or development projects to assess whether these investments generate adequate returns.
• Utilize accounting software to automatically calculate profitability ratios and generate reports, saving valuable time while providing real-time insights for better business decisions.

What do profitability ratios measure?

Profitability ratios are financial metrics that measure how efficiently your business converts spending into profits. They help you understand your business performance by focusing on different types of expenses.

Not all ratios will be relevant to every small business. The key is identifying which ones matter most for your specific situation.

What can profitability ratios tell you?

Profitability ratios give you a clear picture of your business’s financial health. They help you answer important questions about your performance.

By looking at these numbers, you can see if your pricing is right, if your costs are too high. For instance, one analysis found a company’s Salary expense was 53.2% of sales, more than double the industry benchmark, or how well your investments are paying off.

They turn your financial data into simple insights, making it easier to make confident decisions and plan for growth.

Types of profitability ratios

Profitability ratios fall into two main categories, each measuring different aspects of your business spending.

Margin ratios

Margin ratios measure your day-to-day operational spending and show what percentage of revenue you keep after covering costs.

The two essential margin ratios are:

• Gross profit margin: Shows profit after direct costs of goods or services sold
• Net profit margin: Shows profit after all business expenses

Return ratios

Return ratios measure how effectively your business generates profit from major investments and assets. These ratios are most relevant for growing businesses with significant equipment, property, or development costs.

The two key return ratios are:

• Return on assets (ROA): Measures profit generated from all business assets
• Return on invested capital (ROIC): Measures profit from new investments and projects

Using profitability ratios in your business

Start with essential ratios for immediate business insights:

• Track gross and net profit margins: These are crucial for operating sustainability.
• Measure regularly: Know your current ratios to establish baselines.
• Set benchmarks: Define ratios you want to maintain. You can compare your numbers to official industry data, such as the benchmarks published by the ATO for businesses whose turnover is up to $15 million.
• Create goals: Identify target ratios for improvement.

Consider advanced ratios as your business grows:

• ROA and ROIC: Become relevant when scaling operations
• Investment mindset: Even without formal tracking, remember that investments must generate returns

Get professional support for accurate analysis:

• Work with accountants or bookkeepers: They’ll identify the most relevant ratios for your business
• Use accounting software: Tools like Xero accounting software can calculate ratios and generate reports automatically
• Share insights easily: Modern software makes it simple to distribute financial reports to stakeholders

Gross profit margin

Gross profit margin shows what percentage of revenue remains after paying for the direct costs of your products or services.

This margin needs to be substantial because you’ll use this cash to cover general business expenses, and even small, unrecorded costs can have a big impact. One case study showed that unaccounted for freight and potting charges were responsible for most of the decrease in gross margin. These include rent, utilities, marketing, insurance, and administration costs.

Formula for calculating gross profit margin ratio

Learn more in the guide How to measure profitability, and get tips to improve your ratios in How to increase profit.

Net profit margin

Net profit margin shows what percentage of revenue remains after paying all business expenses. This is your true profit, or the portion of sales you actually keep.

Comparing this to industry standards is key, as one business discovered when its net profit margin was (29.39%), a significant difference from the industry benchmark of 13.76%.

Why it matters

• Improving efficiency: Shows you’re effective at converting sales to profit
• Reducing volume dependence: Less reliance on high sales figures to stay profitable
• Creating strategic flexibility: More options for business decisions

Finding your profit sweet spot involves balancing three strategies:

• Lower prices: Increase sales volume to boost total profits
• Maintain prices: Invest more in marketing to attract new customers
• Reinvest profits: Hire staff or improve systems to make operations easier

Formula for calculating net profit margin ratio

* Net profit can be quoted before or after taxes. If quoting after-tax net profit then you need to also subtract taxes.

Learn more in the guide How to measure profitability.

Get tips to improve these ratios in the guide How to increase profit.

3. Return on assets

Return on assets (ROA) measures how effectively your business generates profit from its assets, including property, equipment, and tools.

This ratio is most relevant if your business has significant investments in:

• Expensive equipment: Manufacturing tools, vehicles, or machinery
• Real estate: Owned property or facilities
• Intellectual property: Patents, software, or proprietary systems

Why it matters

ROA is a way of testing the wisdom and efficiency of your investments. A high ratio suggests you’re getting good value out of your assets, while a low ratio may indicate you’ve overinvested in certain areas.

Formula for calculating return on assets ratio

* We use value of assets rather than 'average value of assets' because the latter is for businesses that are buying and selling assets all the time... which doesn't reflect a small business.

Use this formula to work out your return on assets:

Return on Assets = Net Profit ÷ Total Assets

4. Return on invested capital

Return on invested capital (ROIC) measures how effectively your business generates profit from new investments and major expenditures.

This ratio is most valuable when you’re investing heavily in:

• Property and buildings: New facilities or major renovations
• Equipment upgrades: Manufacturing systems or technology
• Intellectual property: Software development or patent creation
• Research and development: New product or service innovation

Why it matters

ROIC will reveal if you wasted money on unnecessary assets or projects so that you can avoid similar mistakes in the future.

Formula for calculating return on invested capital ratio

Track your profitability ratios with the right tools

If you calculate ratios manually, you spend valuable time that could go into running your business. Using accounting software makes it easy to track your profitability without the extra admin.

Xero automatically generates reports like the profit and loss statement, which gives you the numbers you need to calculate your margins in moments. With real-time data at your fingertips, you can monitor your performance, spot issues early, and stay on top of your financial goals. It helps you run your business, not just your books. Try Xero for free.

FAQs on profitability ratios

Here are answers to some common questions about profitability ratios and how to use them in your business.

What are the 5 key types of financial ratios?

The five main categories of financial ratios are profitability, liquidity, solvency, efficiency, and market value. Each type gives you a different view of your business’s financial health.

What are the 3 most common profitability ratios for a small business?

For most small businesses, the three most important profitability ratios are the gross profit margin, net profit margin, and return on assets (ROA). These give you a clear view of your operational efficiency and how well you use your assets to generate profit.

How can you improve your profitability ratios?

You can improve your ratios by increasing your prices, reducing your cost of goods sold, or controlling your operating expenses. Finding the right balance between these actions will help boost your overall profitability.